What is Bankruptcy?

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Definition:

Bankruptcy is a legal process in which people or companies declare they can’t pay their debts and work to settle with their creditors.

🤔 Understanding bankruptcy

Bankruptcy is a legal process in which individuals and companies declare they’re unable to pay their debts and work to settle with their creditors who want to get paid what they’re owed. The process can involve reorganizing a person’s or a company’s debts to make them more manageable, or erasing debts altogether, or liquidating assets. Bankruptcy can offer a person or company a fresh start and relief from an insurmountable debt burden, but they have to give up some control over their affairs, and they might have to liquidate their assets or stop operating their business. Bankruptcy can also make it more difficult in the future for a person to get credit, buy a home, or be hired for a job.

Example

Toys R Us is a business that went through the bankruptcy process. In 2017, the company owed nearly $5 billion to its creditors, with more than $2.1 billion due to be paid in 2018 and 2019. The company recognized it would not be able to meet those obligations, so it entered the bankruptcy process to attempt to reorganize its debts and continue to operate. However, the company was ultimately unable to overcome its financial difficulties and liquidated in 2018. A new company is now trying to revive the Toys R Us name.

Takeaway

Bankruptcy is like clicking “undo” on a financial situation…

When you’ve done something on a computer you don’t want to do and you want to start over, you click “undo.” Bankruptcy is like doing that financially. Sometimes you borrow money with plans to pay it back, but you’re unable to do so. Bankruptcy can shield you from some obligation to repay the debt while you try to recover, and gives you a mostly clean slate — though it can make it harder for you to borrow money in the future.

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What is bankruptcy?

In the United States, bankruptcy is a legal process that gives people and businesses with too much debt a way to reorganize or erase their debt. Bankruptcy can help someone set up a plan to repay their creditors in a manner they can handle while continuing to operate. The creditors, in turn, can recover at least some of what they’re owed.

After completing the bankruptcy process, an individual or company can be free from their previous obligations. (In some cases, however, a person or business may have to liquidate - selling all assets except those that are exempt, with the money going to help repay creditors.) . Bankruptcy reorganization helps them get out from under insurmountable amounts of debt, but it can make it more difficult to borrow money or get a credit card after they finish the process.

What are the types of bankruptcy?

There are different types of bankruptcies, corresponding to the different situations and goals that debtors may have. They are generally known by the different parts of the U.S. Bankruptcy Code in which they’re detailed. The most common types are Chapter 7, Chapter 11, and Chapter 13 bankruptcy.

Chapter 7

Chapter 7 bankruptcy refers to liquidation, meaning the sale of the debtor’s assets and the total erasure of all eligible debts.

For Chapter 7, as for Chapters 11 and 13, a person or company must file a bankruptcy petition, pay filing and administrative fees, and provide supporting documents, including lists of their assets and debts and their current income and expenses, a statement of their financial situation, and their tax transcripts.

In Chapter 7 bankruptcy, a court-assigned trustee is responsible for selling all of the debtor’s non-exempt assets. (Assets that are exempt from liquidation vary from state to state, but often include cars, necessary clothing, reasonable household goods and furniture, appliances, some professional tools, and a portion of ownership in the debtor’s home.) The trustee then uses the money raised from the sales to pay the person’s creditors at least part of what they’re owed.

Once the trustee liquidates the individual’s assets, the court discharges their remaining debts. That means those debts are erased and the person no longer has to pay them.

Chapter 11

Chapter 11 bankruptcy is typically used to reorganize a business, though it is also available to individuals. This allows the company to come up with a plan to repay its debts while it continues to operate. Otherwise, it might have to sell off assets and go out of business.

In Chapter 11 bankruptcy, the business continues operating while a U.S. trustee or bankruptcy administrator monitors the company to ensure it reports its income and expenses accurately. The trustee or administrator also appoints a creditors’ committee, typically consisting of the seven creditors to which the business owes the most money and whose claims aren’t secured by the company’s assets. The committee also monitors the company’s operations and works with the company to create a plan to pay its debts.

There may be multiple proposed reorganization plans submitted to the court during a Chapter 11 case. There may be a period when only the debtor has the right to file a plan, but the creditors’ committee may ultimately be able to file its own competing plan. A plan can either fully liquidate the borrower’s assets, like a Chapter 7 case, or can establish a payment setup for the business to follow.

Once the court, debtor, and creditors confirm a plan, the borrower must begin following that plan and complete all payments laid out by the plan. In return, their remaining debts are erased.

Depending on how much a company owes and what sort of obligations it has, some creditors in a Chapter 11 case may get paid little or nothing. Generally, secured creditors (those whose claims are backed by the company’s assets) get paid first, then holders of unsecured claims, and finally the company’s shareholders.

Chapter 13

Chapter 13 bankruptcy lets individuals who have regular income reorganize their debts, paying a portion of what they owe over three to five years while discharging the rest. To be eligible, the borrower must have unsecured debts under $394,725 and secured debts under $1,184,200.

The advantage of Chapter 13 bankruptcy is that it may allow the borrower to retain their assets, including their home, while discharging a portion of their debts. It can also provide protection to people who co-signed the borrower’s loans.

In Chapter 13, a trustee or bankruptcy administrator hosts a meeting between the filer and their creditors. The administrator and creditors can ask the filer questions about their finances and attempt to resolve any problems with the debtor’s proposed payment plan, which is then filed with the bankruptcy court.

The program usually involves biweekly or monthly payments. Generally, it must provide full payment to the holders of priority debt (claims with special status under the law, such as taxes and the costs of the bankruptcy proceedings), and must pay holders of secured debt at least the value of the collateral that underlies the debt. A payment plan doesn’t have to provide full payment to creditors holding unsecured debt, but the creditors must get all of the debtor’s projected disposable income during the payment period. The remaining debts are discharged.

Other types of bankruptcy

Outside of Chapters 7, 11, and 13, there are bankruptcies designed for specific situations or groups of people. For example, Chapter 9 bankruptcy is used by municipalities, while Chapter 12 bankruptcy is reserved for family farms.

Involuntary bankruptcy

Under certain circumstances, the creditors of a person or company can petition the bankruptcy court to force a debtor into Chapter 7 or 11. For any debtor with more than a minimal number of creditors, at least three creditors must band together to file an involuntary bankruptcy petition, and they must demonstrate that the debtor is generally not paying their debts as they come due. The debtor can respond by filing bankruptcy itself voluntarily, or it can contest the petition, in which case the court has the final say.

What are the advantages and disadvantages of declaring bankruptcy?

The advantage of declaring bankruptcy is that it can give you a breather from your obligation to pay your debts while you try to reorganize your finances. If you don’t have enough to repay what you owe, the bankruptcy process can help you set up a payment plan and get out from under debt that you can’t repay.

The disadvantage of declaring bankruptcy is that it can have serious, long-lasting effects on your life and your finances. Depending on which type of bankruptcy you file and your individual situation, you could have to sell all of your assets to cover your debts. You’ll spend years following your payment plan.

You will probably find it harder to borrow money. Bankruptcies remain on your credit report for 7 to 10 years, which can heavily damage your credit. Lenders tend to see Chapter 13 bankruptcies as better than Chapter 7, but any kind of bankruptcy can hurt your ability to get a loan or a credit card. Many of your previous lenders may close or limit your accounts with them, giving you limited access to credit.

Your employment and living opportunities could also be affected. Bankruptcies are public record, and potential employers, landlords, or anyone researching your background will be able to see that you filed for bankruptcy. That could reduce your chances of being offered a job or renting an apartment.

Do you get out of debt with bankruptcy?

The point of bankruptcy is to give a debtor a mostly fresh start financially. So bankruptcy can enable you to get out of paying some of what you owe, although you’re responsible for paying as much of your debt as possible. Some loans, like student loans, cannot be erased through bankruptcy.

Once you devise a payment plan and the bankruptcy court approves it, you must follow it. After you’ve fulfilled the plan to the court’s satisfaction, your remaining debts will be discharged.

What do you lose in bankruptcy?

When you declare bankruptcy, you lose some control over your financial life. During the bankruptcy process, you have to follow rules about how you can manage your money, and you work with a trustee or bankruptcy administrator and a group of your creditors who have influence over the payment plan that you ultimately have to follow.

In a bankruptcy that involves liquidation of assets, you’ll also lose some of your assets when the trustee or administrator sells them to pay your debts. Certain assets, like clothing and personal items and professional tools you need to make a living, won’t be sold, but most of your assets will likely be liquidated.

If you had a good credit score, you’ll also lose that. Bankruptcy has a significant effect on your credit and can make it hard to qualify for future loans.

Who pays for bankruptcies?

When you file for bankruptcy, you have to pay filing and administrative fees. You also have to make payments under the payment plan you establish during the bankruptcy process.

Any amount that you owe to a lender, but do not pay through the payment plan, does not get paid by a third party. Instead, the lender must write off the amount it couldn’t recover from you. In this way, lenders pay for bankruptcies.

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